Reality check (fiscal policy)

The IMF has just published their November 2009 edition of "The State of Public Finances Cross-Country Fiscal Policy Monitor". It is a great analysis of the current state of public finances and the risks ahead.

Some good news: if one looks carefully at the numbers, while deficits and debt levels are high, they are manageable. They require an effort in the years (decades?) ahead but we have seen large fiscal consolidations in the past of a size which is similar to what is required from today's perspective. This seems to be the perspective of financial markets as interest rates on government bonds remain low and there is no obvious pricing of a default risk.

The arithmetics of fiscal discipline are simple and the future effort will depend on the difference between the interest rate that governments will face and the growth rate of their economy. In emerging markets, we have seen rapid changes in this difference (interest rate getting very high as growth rates slow down) leading to crisis as the burden becomes unmanageable. While this is not the scenario that one might expect for advanced economies, it all depends on the credibility that governments established. And theoretically one could imagine a self-fulfilling prophecy where a crisis starts with a small change in the perceived credibility of governments which increases interest rates and leads to unsustainable interest payments.

The bad news is that there is no guarantee that governments will behave better going forward. Yes, we know the effort that is needed to stabilize debt-to-GDP ratios but history is full of examples where once the crisis is over we forget about fiscal policy discipline. And here is where we need an exit strategy. It is not about about announcing a short-term schedule to remove the current fiscal stimulus is about giving reassurances that in the next decade or decades we will look at sustainability of government finances in a different way. I have argued in some of my academic research (together with my co-blogger Ilian Mihov) that there is a need to think about institutional reforms that change the way we think about fiscal policy and budgets. Other academics have presented similar proposals, all of them implying the creation of some constraints around the power of governments to decide on all aspects of fiscal policy. While numerical rules are the simplest way to think about constraints (budget balance rules, stability and growth pact), the empirical evidence is that implicit constraints - such as those created by the political process through which budgets are decided- can be as powerful and less rigid. A change in this direction would be a good "exit strategy" for governments. Without the need to harm the current recovery, it would provide the necessary foundations for a credible fiscal policy in the years ahead.

Antonio Fatás

Extending the (EMU) Stability and Growth Pact to take care of global imbalances

Last week Eswar Prasad had an interesting article in the Financial Times on how to deal with global imabalances. As the G-20 seems to be taken the issue of global imbalances seriously, there is the question of how to make their commitment operational.

Reducing global imbalances requires a reductio in national imbalances between income and spending or, in other words, between saving and investment. The difficulty is that this imbalance is the result of both government and private sector imbalances. Because it is difficult to think about how to effectively impose a balance on private income and spending, the only valid alternative seems to be addressing large imbalances in government spending.

This is the suggestion of Eswar Prasad:

"The scheme would work as follows. The G20, in consultation with the IMF, develops a simple and transparent set of rules for governments on policies that could contribute to global imbalances - for instance, that government budget deficits and current account balances (deficits or surpluses) should be kept below 3 per cent of national GDP"

If deficits go beyond 3% there is a financial penalty (implemented through the SDR holdings of the IMF). If we focus on budget deficits, this looks like the Stability and Growth Pact under which EMU governments have lived for several years. There is a limit on budget deficits (3%) and a set of mechanisms to enforce this limit.

The history of the Stability and Growth Pact has shown us that it does not work. While it provided some discipline in the earlier years, we soon realized that there were many issues associated to its implementation that have led to failures to comply with the limits and a revision of the Pact that has left very little power over national government balances. The issues were many:

- What do you mean by 3%? You probably want to adjust this by the cycle, but then how do you adjust it by the cycle? Do you allow for exceptional circumstances?

- How do you punish government? Who decides that governments should be punished? (in the case of EMU, it was the council of finance ministers who had to punish some of its own members, not very effective).

In practice, many countries ended up with deficits above 3% without significant consequences. There were also periods where the government deficit was below 3% but the government was clearly helping create a current account imbalance (i.e. the government should have had a large surplus as opposed to let's say a 2% deficit).

The G-20 commitment to address global imbalances is no doubt a good step in the right direction but it is unclear how this commitment will translate into specific outcomes or actions.

Antonio Fatás

Content of economic blogs

Here is a snapshot of recent content of some economic blogs (thanks to Wordle).

Greg Mankiw

Mark Thoma

Brad de Long

Casey Mulligan

Antonio Fatás

How low is 1.48 (USD/EUR)?

As we witness increasing signs of economic optimism about the recovery, the focus of the analysis turns into the exact form that the recovery will take and how to ensure that it is as fast and smooth as possible. One of the areas that has received recent attention is the evolution of the US dollar. In recent months the US dollar has gotten weaker and there are many questions about whether this is a trend that will continue and how far the US dollar will fall.

In an FT article yesterday Wolfgan Munchau made the case for a weaker dollar. Many of the arguments are not new and we had heard them before the crisis when global imbalances were on their way up. As the US current account deficit got larger and larger there was the question of how those deficits would be reduced. Given that (US) consumption rates looked unsustainable, it seemed that a price adjustment (through a change in the exchange rate) was the only way to produce that adjustment. In addition, now that the crisis has started, and if one takes the perspective of the US economy, a depreciating currency can help with the economic recovery, an argument made by Wolfgan Munchau in yesterday's article

"A lower dollar is desirable because it would help America achieve the right kind of recovery. The US economy is severely constrained by household and financial sector deleveraging and possibly by a permanent fall in potential growth. In the absence of another housing bubble and consumer boom, an export-led recovery is the best growth strategy the US could employ."

This argument is similar to the one made by Krugman to oppose those who are voicing concerns about the fall in the value of the US dollar.

I will not argue here with this textbook logic of how currency movements can help address current account imbalances and business cycles (although I must admit that I find the empirical evidence much weaker than most people). But I have some concerns about blank statements that argue that the US dollar has to get weaker:

1. It is not enough to say that the US dollar has to get weaker you need to say how weak it should get, we need a number, there is a need for a medium/long-run anchor. As the chart below shows, the US dollar is already weak by historical standards. Sure, it has room to get to the historical low of 2008 but was is the right reference value?

As a technical and historical explanation of the chart: this is the nominal exchange rate between the US dollar and the Euro (before 1999 the German Mark is used as the Euro) and the upward trend is a reflection of the differences in inflation between Europe/Germany and the US. But even if we were to correct for inflation differences, the US dollar is still weak by historical standards. Also notice that some of the waves that we see were reversed by some statement coming from central banks and government officials, such as the September 1985 Plaza Accord, the February 1987 Louvre Accord and the interventions of November 2000. By historical standards, we would have expected similar statements in 2008 when the US dollar reached the 1.60 USD/EUR level. We did hear some comments about "excessive volatility" but not about the actual value of the currency.

2. Related to the point above, but more from a theoretical point of view: how much do we want to introduce price distortions (changes in relative prices via changes in the exchange rate) to ensure that the spending patterns of different countries are sustainable? The textbook logic of currency depreciations to smooth recessions is one that applies to countries that are suffering an asymmetric shock. Today we face a global recession, so according to the textbook, most advanced economies need an exchange rate depreciation. We might argue that all these currencies need to depreciate relative to countries that are doing well (China and other emerging markets) but we cannot simply argue that the US dollar has to get weaker. It is interesting how many criticisms China has gotten for "manipulating" the value of its currency to affect economic outcomes and now we are willing to argue that the US should be doing something similar. Just to be clear, I am not arguing that currencies cannot be a good adjustment mechanism, but the context matters and one needs to be explicit about the difference between an asymmetric recession and a global recession and the difference between smoothing business cycles and addressing structural imbalances.

3. The perspective of the other countries. A weak dollar can help the US increase its exports, which goes in the direction of reducing the current account deficit, but why would other countries see this as a "return to equilibrium"? Wolfgang Munchau argues that "A strong Euro would nicely take care of of Germany's persistent current account surplus". I am not sure all the Germans agree with this statement. I am also not sure that a fall in revenues (i.e. fall in German exports) would lead to a decrease in the saving rates in Germany. It might lead to the opposite behavior - an increase in saving rates because the decrease in income leads to more uncertainty and precautionary savings (which will make the current account surplus even larger not smaller).

Antonio Fatás

More on the medium-term outlook for the recovery

The magazine The Economist has an article this week on the persistence of the current recession and whether output will return to its trend. The arguments that the article present are similar to those made in the Chapter 4 of the recent World Economic Outlook by the IMF (see our previous post on this matter): it is likely that the current recovery is not strong enough to bring output back to trend. In a recent NBER working paper, Cechetti, Kohler and Upper also provide empirical evidence suggesting that financial crisis leave long-lasting (negative) effects on output.

The question on the connection between recessions (or business cycles in general) and potential output ("the trend") is one that has not been studied much in economics. Most of the models we use tend to think about the trend as being independent of business cycles - so recoveries always bring output back to the pre-crisis trend. Policy makers tend to use the concept of the output gap, the deviation of output from its potential, to think about the strength of the recovery under the assumption that in a "normal" year the output gap should be back to zero.

The strongest evidence one can find in favor of this hypothesis (that recessions are temporary) comes from the US economy. The US economy has displayed a surprising tendency to return to trend even after some major events such as the great depression, World War II or the recessions of the 70s. Below you can see a chart that shows the evolution of GDP per capita in the US during the period 1870-2008. The red line represents a (log-)linear trend using data up to 1928. It is remarkable how close the blue line is to the red line and how the economy recovers to return to trend.

In fact, using 1870-1928 data, a prediction using that (log-)linear trend leads to an error of only 1% for the level of GDP per capita in 2008. Of course, the picture is misleading in the sense that in some cases it took a long time for the economy to come back to this trend, but it is still interesting that it returned to the same trend. It could have returned to the same growth rate but at a different level but that's not what we see, we see that the output loss is always recovered after a number of years. This suggests that the supply side of the economy (innovation, technology) is unaffected by output fluctuations.

If one looks more carefully at the data, the evidence becomes much weaker. In contradiction to what we see in the picture above, empirical economists know that output fluctuations are very persistent. In fact, one cannot reject the hypothesis that all output fluctuations leave a permanent scar in the economy. If we suffer a recession, output never goes back to trend, it remains at a lower level forever (this is what is known in the academic literature as the existence of a "unit root" in output).

From a theoretical point of view, there are two ways to justify the fact that recessions always leave permanent effects:

1. Technological changes are the cause of business cycles. Recessions are period where we are not good at innovating and this causes both a recession and a permanent loss in output. This is what we know as "real business cycle theory".

2. Innovation is affected by recessions. During recessions firms invest less and this lead to a temporary slowdown of technological progress, so the economy never returns to the same trend. It will go back to its normal growth rate but the temporary effects on growth will leave a permanent scar on the economy. This is the argument that we hear these days to support the fear that the current recovery will not be strong enough. A few years ago I wrote a couple of academic papers that presented this theory and some international evidence in favor of this hypothesis (the papers can be found here and here). This is an area of macroeconomics that I believe deserves more attention in terms of academic research (but I am biased, given that I have written on the subject). And it is not just about financial crisis but, more generally, about what happens to innovation, technology and growth during recessions.

Antonio Fatás

Will output return to the pre-crisis level?

How strong the economic recovery will be depends on whether we believe that output will quickly return back to the trend that was following before the crisis. Economists tend to think in terms of potential output as driving the trend of output and recessions as being temporary deviations from this trend. During the recession the output gap becomes negative (output is below potential) and the recovery brings output back to its trend, closing the output gap.

There is, however, evidence that output does not always return to its trend after a deep crisis. The IMF World Economic Outlook has just released its two analytical chapters from the September/October issue. Chapter 4 (which can be found here) deals with this issue: whether output will return to trend after the crisis. Their conclusion, after looking at many different historical cases, is that banking/financial crisis tend to leave a permanent (or at least a medium-term) scar on the economy. Here is a picture from Korea after the 1997 crisis (picture borrowed from Chapter 4 of the World Economic Outlook).

As we can see, 7 years after the crisis, output is still far from the pre-crisis trend. There are many other examples like this one and the evidence supports the notion that there is a mid-term costs of financial crisis so that output stays below trend for several years.

There are, however, some examples where the output loss is smaller. Some of the conditions under which the mid-term output cost could be low are:

- having a low initial decline on output (e.g. the severity of the recession during the first quarters).

- having a level of investment before the crisis which is not far from historical standards (e.g. the pre-crisis boom did not drive investment rates too far from historical levels)

- having more policy room to maneuver (low inflation, current account balance) before the crisis

The conclusions of the article state that:

"For the most part, the implications of our analysis are sobering for the medium-term output prospects in economies with recent bank- ing crises. The historical evidence suggests that output in many of these economies may remain well below precrisis trends in the medium run."

And policy makers are warned once again about the difficult balance in their exit strategies.

"Looking ahead, the timing for the withdrawal of the extraordinary amount of monetary and fiscal stimulus that has been implemented in many countries will be impor- tant. On the one hand, a premature exit could stifle the recovery. On the other hand, delaying the withdrawal of stimulus could be inflationary."

Antonio Fatás

Output, employment and productivity during the crisis

While most advanced economies have displayed significant drops in GDP during the last years, the behavior of labor market variables (employment, unemployment, number of hours) has been quite different across countries.

In countries such as the US or Spain we have seen a large decline in employment/hours and the corresponding increase in unemployment. In countries such as Germany or France or Sweden, employment and hours have fallen much less.

Below is data on labor productivity measured as GDP per hour worked in four countries (data is annual so we are missing the first quarters of 2009). In the case of Sweden and Germany we can see that the fall in GDP has been much larger than the decrease in hours worked leading to a decline in productivity. In the case of the US productivity has remained stable. In the case of Spain the fall in employment and hours has been much larger than the decrease in GDP which has produced a doubling of the productivity growth rates in 2007/08 relative to the 2003-06 period.

Behind these figures we probably have a composition effect (different sectors being affected differently by the crisis) but also different labor market responses to the crisis, where in some cases there has been a conscious effort to reduce the impact on employment.

Antonio Fatás

Update (Sept 23): some have emailed me asking for an explanation of the differences among these countries. I do not have a great answer, my last paragraph was an attempt to put forward some hypothesis. It could be that the sectors that are being affected in a country like Sweden are the most productive ones, while in a country like Spain they are the least productive ones (e.g. construction). I have no evidence that this is the case but it is a plausible mechanical explanation. The second explanation that I proposed is probably more realistic: in some countries (Germany, Sweden) there has been a conscious effort with the help of trade unions to reduce the impact of the crisis on employment (e.g. accept a pay cut if the level of employment is maintained). We have not seen this in the US. In the case of Spain, the dual structure of the labor market has led to a large termination of temporary contracts and a significant reduction in employment.